SPECIAL FOCUS: CAPITAL MARKETS OUTLOOK 2008

APARTMENT FINANCE TODAY • JANUARY 2008

Conduit Lending Falls Off the Table

The CMBS market must stabilize before conduits can make competitive spread quotes—and no one knows when that will happen.

By Brad Berton

As traumatized conduit lending officers usher in the new year, they can’t help wondering when they’ll finally get comfortable again quoting apartment mortgages at interest-rate spreads comparable to their primary competitors: life insurance companies and housing agencies Fannie Mae and Freddie Mac.

The optimists think stability could return to the commercial mortgagebacked securities (CMBS) marketplace this winter or spring. That would end a nightmarishly volatile period during which conduits have been hamstrung in quoting loan spreads, for fear of losing money because of another sudden jump in CMBS bond yields.

The skeptics think a more predictable spread environment might not return until 2009.

Until the volatility hit amid fallout from the subprime residential mortgage distress last summer, the CMBS arena had become solidly predictable, with bond yields shifting maybe a basis point or two over the course of a month, said Clay Sublett, senior vice president and CMBS manager with KeyBank Real Estate Capital.

“Now it can be 10 or 20 [basis] points in a matter of weeks, and that makes it very difficult to price new loans,” Sublett said. “So when someone calls for a quote, your inclination is to hide under your desk and not answer the phone.”

The CMBS marketplace has “become less stable week after week,” said Brett Smith, managing director and head of mortgage origination and placement for Wachovia Bank’s Real Estate Capital Markets Group. “It’s virtually impossible to determine with any degree of accuracy where our break-even point is in quoting a spread on a loan we’re looking to close 30 to 45 days later.”

Smith and Sublett rank among the optimists expecting a more predictable environment to re-emerge by spring, as the supply and demand for mortgage- backed bonds return to nearequilibrium. While other experts foresee a longer rough ride, there appears to be strong consensus that borrowerfriendly interest spreads, underwriting practices, and related loan terms will not return even when the CMBS market stabilizes.

Bond yield volatility had occasionally pushed conduit spread quotes well into the mid- and even high-200s during the fourth quarter of 2007.

Borrowers will also face tighter underwriting parameters from conduits. “Underwriting practices are taking a step back and will look more like they did in 2004 and ’05 rather than the very liberal terms we’ve seen the last couple years,” Wachovia’s Smith said.

Forget about full-term interest-only loans at full leverage based on expectations of lofty rent increases, said conduit veteran Dan Smith, managing director overseeing conduit lending at RBC Capital Markets. “You need cash equity and you need to amortize— those are terms that haven’t been used for a while.”

Borrowers should expect traditional underwriting standards including leverage of 75 percent and no more than 80 percent—and limited by actual debt coverage rather than aggressive cap rate-based valuations, RBC’s Smith said. Conduit underwriting will no longer factor in rent inflation expectations, as had often been the case over the last few years. And reserves actually have to be collected, not just underwritten as a formality, he added.

All that points to much less lending by conduits this year. Experts wonder whether originations for securitization this year will reach even half the $230 billion estimated for new CMBS issuance in 2007.

The implication is that conduits will concede a considerable share of the commercial mortgage lending market to life companies and other portfolio lenders, and to Fannie and Freddie as well.

Lehman Brothers Managing Director Larry Kravetz predicted the volume of apartment loans originated by conduit lenders will be sliced in half this year. KeyBank’s Sublett said his expectations were similar, and he added that the decline is bound to diminish the conduit marketplace’s share of income-property lending dramatically from its high of around 75 percent in early 2007.

Wachovia’s Smith and others agreed that conduits aren’t going to be writing a lot of loans for Class A apartment properties until they’re able to quote spreads on par with Fannie Mae, Freddie Mac, and life companies. But as capital markets volatility continued in November and many conduits were still quoting spreads well beyond 200 basis points over Treasuries, the government- sponsored enterprises (GSEs) and insurers were doing deals generally in the vicinity of 150 to 175 basis points over Treasuries, Sublett said.

“I just don’t think conduits will be a factor for at least the first six months of the year,” said Peter Donovan, senior managing director with CB Richard Ellis Capital Markets. “Fannie and Freddie will have a significant advantage in multifamily lending throughout 2008,” he said.

All of which has insiders wondering whether some of the dozens of active conduits will opt out of the sector in 2008. And the consensus here seems to be that smaller shops relying heavily on conduit lending would be the first to go—especially those new to the game.

Conduit lending operations that are part of “multi-product” organizations able to tap GSEs, other portfolio lenders, and their own balance-sheets can best weather the capital markets storm, Sublett said. Some lenders reliant on Wall Street to ultimately fund loans may not see sufficient volume— and hence profits—to justify continuing to do conduit business, he added.

None of the experts suggested that any of Wall Street’s biggest investment banks appears likely to exit the conduit arena. Credit Suisse First Boston, Lehman Brothers, Morgan Stanley, Merrill Lynch, Bear Stearns, and Goldman Sachs all ranked among the 15 most active contributors of conduit mortgages to CMBS issues during 2007’s first three quarters, according to a report from Commercial Real Estate Direct news service.

When the capital markets do stabilize, conduit debt will likely be available at a cost in line with traditional spreads. During the lending frenzy of early 2007, the most creditworthy owners of well-positioned apartment properties saw spreads quoted at 100 basis points over Treasuries or even lower from conduits.

Chances are spreads won’t get anywhere near that tight any time soon—if ever. “I don’t know if we’ll go back to 125 [basis points] over [Treasuries]—or even 150” within the coming 12 to 18 months, Donovan said, adding that predictions of 150 to 200 basis point spreads seem reasonable.